On Aug. 2, the IRS issued proposed new regulations that, if adopted, would restrict or eliminate valuation discounts for gifts or other transfers of minority interests in entities such as LLCs, LLPs, limited partnerships and corporations. Transfers of minority interests in farm entities have been a common and important method in farm succession planning.
The primary goal in farm succession planning is the transfer of management and eventually ownership of the family farm to the next qualified and committed generation. Usually the parents form an LLC, which then owns the farm personal property and often, the primary building site. Sometimes they will also form an LLC to own all or part of the farm’s land base. The parents then gift or sell a minority interest in the entity to the active children. Gifts of “earned equity” are most common as the farm needs to continue reinvesting its cash flow in the farm.
For purposes of this article, we will assume the transfer of a minority interest in a farm entity by the parents to an active child or children. Under current rules, the parents can transfer a minority interest in an entity at a discounted value, which limits the amount that needs to be reported as a gift for gift tax and eventually estate tax purposes.
The value of the minority interests can be discounted because control of the entity is disbursed between multiple owners. Presently, such discounts may include: (1) a discount for lack of marketability as an interest in a family business entity, especially the entity operating the farm business, cannot be easily sold; (2) a minority discount if the transferee owner lacks a controlling interest; and (3) a smaller discount if the transferred membership units or stock lacks voting rights. Eventually, the senior generation’s interests can be discounted if they then hold a minority interest. These discounts can result in a reduction in reportable value for gift and estate tax purposes of 20% to 40% or more.
Value of gifting
Discount gifting is especially important for farmers with large estates and estates that are growing in value. Lifetime gifts of over $14,000 per year per donee reduce the amount that is exempt from estate tax upon the donor’s death. The current combined gift and estate tax exemption amount is $5.45 million per person (or $10.9 million per couple). However, presidential candidate Hillary Clinton has indicated her goal of reducing the federal exemption to $3.5 million per person (or $7 million per couple). The top tax rate above the exemption is 40%. Therefore, discount gifting should be considered as a long-term planning step as the transfer includes not only the gifted interest in the entity but also the future growth in that percentage of the entity’s value.
The proposed changes in the rule would allow the IRS to ignore many discounts in transferred interests that currently apply allowing the collection of more estate or gift taxes. Generally, the discount for minority interests would be substantially eliminated if the family remains in control of the entity. The family would include parents, descendants, brothers and sisters and any spouses. In addition, the IRS would disallow discounts if the taxpayer dies within three years of making certain gifts.
The IRS has requested comments by Nov. 2, and will hold a hearing on Dec. 1. Therefore, the regulations could take effect in 2016. It is likely that the comments received by the IRS will cause modifications to the proposed regulations and delay their adoption. It is possible that the regulations could be finalized and effective in 2017. However, the IRS has indicated that changes in the rules regarding valuation discounts are a high priority.
Tax attorneys and accountants are uncertain as to the final form of the new regulations and when, or even if, they will be adopted. Some question the authority of the IRS to make the proposed changes, while others expect a court challenge unless there are substantial revisions to the proposed rules. The final form of the new regulation and possible date of its adoption is unknown at this time. However, it is clear that the current administration is pushing for adoption before a new president takes office.
In any event, any transfers made before Dec. 2 should be subject to the current rules. Transfers made later, but prior to, the eventual adoption of new rules will likely remain subject to the current rules. As such, there is a window of opportunity for discount gifting under the current rules.
To fully benefit, an entity that qualifies for minority valuation discounts would need to be established and/or transfers made of minority interests before the new rules take effect. Farmers, who have existing entities, should review their situation and decide whether initial or additional gifts should be made before the rules take effect.
Twohig is a partner in the ag law firm of Twohig Rietbrock Schneider & Halbach S.C. Call Twohig at 920-849-4999.